Relief For Indirect Transfers! Short-Lived?

Since the 2012 Vodafone Supreme Court judgment, there has been a Damocles Sword hanging over indirect transfers! As you know already - the judgment was followed by a retrospective amendment in the Budget that brought within the tax net all overseas transactions involving substantial underlying assets in India. But the definition of substantial remained unclear. It is this confusion that the Delhi High Court has now cleared. Payaswini Upadhyay reports on the precedent this Delhi High Court order sets and if it will be short lived in the light of the impending general anti avoidance rules?

It will go down in histroy as india’s most infamous tax case. Promptly after the Supreme Court’s Vodafone judgment in 2012, the government made a retrospective amendment that proved to be ominous for indirect transfers. The amendment said that ‘any share or interest in a company or entity registered or incorporated outside India, shall be deemed to be situated in India, if the share or interest derives, directly or indirectly, its value substantially from the assets located in India.’

But what was substantial was left open ended.

Anu DuttPartner, Dutt Menon Dunmorrsett“Because of the Vodafone judgment, where the argument was that one single share in Cayman Islands was transferred but the underlying assets and the value was entirely in India and therefore the government argued that the share was vesting in India- this was rejected. And to overrule the said judgment, this amendment came in 2012 purporting to be a clarificatory amendment and it said that share even outside India would be deemed to be situated in India if the substantial value of that share is in India. Unfortunately there is no definition of substantial.”

Mukesh ButaniManaging Partner, BMR Legal“It sent out a whole lot of nervousness in the mind of taxpayers. It did make many investors believe that to the extent contracts have been signed earlier on a predication that this income is not liable to tax, suitable warranties and tax indemnities were exchanged in relation to those transactions. So people started looking at what this would mean from a liability standpoint.”

Unsure of its liability, Mauritius based Copal Research approached the Authority for Advance Rulings or AAR for its transactions with US based Moody’s. The transaction transferred Copal’s global business to Moody’s and was effected by way of three separate agreements. Two of the three agreements resulted in transfer of Copal’s India assets to Moody’s. The parties approached the AAR to determine the taxability of gains arising out of these two transactions.

The tax department argued that the two transactions should not be looked at in isolation. The department alleged breaking up the transaction into 3 parts allowed the parties to take benefit of the Indo-Mauritius tax treaty. The Department said it should be treated as a singular transaction and the gains arising from the overseas transfer of shares should be taxable as the assets were located in India. The taxpayers argued commercial rationale and the AAR agreed. It held that capital gains arising on sale of shares will not be taxed in India and so, there would be no withholding obligation.

Mukesh ButaniManaging Partner, BMR Legal“I think the AAR merely looked into the fact that this income was liable to tax or not under the indirect tax rule and came to the conclusion the given the sequence of steps that were followed, this income was not liable to tax.”

Recently, the Delhi HC upheld the AAR’s order.

It pointed out that breaking up of the transactions into 3 parts had a commercial effect which could not have been achieved otherwise. And so the department’s argument that the transactions were structured such to just avoid tax is not tenable.

But the High Court didn’t stop there. It went on to assess the value of Indian assets getting transferred and concluded that only 23% of the value of shares is derived from assets situated in India. The court interpreted the term substantially to say that for the indirect tax provisions to apply, the overseas company should derive at least 50% of its value from Indian assets. In doing so, the Delhi HC relied upon the 2010 Direct Tax Code Bill, Shome Committee’s Report, the OECD and the UN Model Tax Convention – all of which prescribe a 50% threshold.

Anu DuttPartner, Dutt Menon Dunmorrsett“What is important is this judgment has looked at the commercial aspects of the transaction and also giving meaningful interpretation of investment companies or companies which are set up In Mauritius where they invest or provide only intra-group services and not that it necessarily has to be in manufacturing or some substantial manufacturing activity for it to have substance. I think that’s an important aspect of this judgment.”

Mukesh ButaniManaging Partner, BMR Legal“The other development that took place when the Andhra Pradesh HC gave a decision in the case of Sanofi. The Andhra Pradesh HC, without looking into the amendments to the domestic law, focused on the India France Treaty and it said that within the realm of India-France Treaty and even after reading the retrospective amendment, you cannot bring that tax to India. Now the Delhi HC has come back and out the substantial part of the debate on indirect transfers to rest. The Committee which has been set up by the Finance Ministry can pick up clues from the Shome Committee recommendations, from the Andhra Pradesh HC’s Sanofi decision and the Delhi HC decision in the case of Copal – so these three in my view will act as aids for interpretation of the law.”

But not for long! The General Anti-avoidance rules become effective in April next year and the worry is that it may dilute the effect of this Delhi HC ruling.

Anu DuttPartner, Dutt Menon Dunmorrsett“Definitely, GAAR may have an influence because it will depend on how the DTA plays out – would they, like in United States, have a provision that the GAAR will overrule the Treaty or will they say the tax office can look at whether DTA should be made applicable in these cases and what will be the interplay between them- so it will depend on that.”

The other moving part of this equation is the Direct Taxes Code- the recent Draft proposes that if 20% ore more of the total assets of a company are located in India, then the income arising from such a transaction will be taxed here. Experts have criticized this threshold saying that by no measure can 20% be considered as substantial. So while for now, the Delhi High Court order has brought cheer, it is short lived – pending the new DTC or GAAR implementation.